Full of EM promise
David Turner finds elements of factor investing that could make the strategy ideal for emerging markets
At a glance
• Proponents of factor investing say it is particularly suited to emerging markets.
• Inefficiencies in emerging markets create factor investing opportunities.
• Factor investing can more easily be used for fixed income in emerging than developed markets.
• The total value of factor investing in emerging markets is still small.
Proponents of factor investing say it is particularly suited to emerging markets precisely because it is so difficult to do.
David Purdy, portfolio manager at Acadian Asset Management in Boston, sets out a few among the many difficulties. “There are fewer analysts, which means there are only so many analysts’ notes and earnings revisions for the market to react to. That makes building a growth factor harder,” he notes. To take another example, “data is limited, so if you want to build a quality factor you may have to sacrifice information on insider trading by management and certain accounting-line items that can be critical dimensions of quality”.
This creates greater mispricing in emerging markets than in developed markets, says Purdy. If investors are buying and selling emerging market stocks based on different information, the opportunity for factor investing, based on rigorous analysis of factors such as quality, is all the greater.
The notion that emerging markets are particularly suited to factor investing is echoed by Dimitris Melas, global head of equity research at MSCI in London, who describes emerging markets as “less efficient”. He adds, also, a crucial point: that they are more driven by momentum.
Momentum is useful for factor investors in emerging markets because if they have enough faith in companies identified using quality and growth criteria, they can take advantage of the indiscriminate selling and buying practised by investors during moments of market mania. Purdy of Acadian refers, for example, to the jettisoning from portfolios of all types of oil companies when the price of crude oil falls as a case of “guilt by association”.
Guilt by association often delivers an unfair verdict, as any defence lawyer will tell you. It certainly does for small and mid-cap emerging market oil refiners in Eastern Europe and India, which have been sold off when crude prices have dipped despite the fact that they stood to benefit from falling crude prices, which tend to raise their margins.
Ana Harris, EMEA head of equity portfolio strategists at State Street Global Advisors (SSGA) in London, has a broadly similar view, although she emphasises the difficulties of trading in emerging market stocks more than the lack of information. “Investing in emerging markets is harder and more costly than for developed markets: trading costs are higher and liquidity is sometimes thinner,” says Harris. But she adds: “This means that anomalies and premia can persist for longer.” Harris notes that the value and size factors are strong, for example.
Niall O’Leary, Harris’ Dublin-based fixed-income counterpart, says that factor investing for emerging market debt works better than for developed markets. “Emerging markets debt has been a challenging environment for active managers,” says O’Leary. “But factors can be used as a way to attack emerging market debt and deliver a consistent investment outcome.”
SSGA does this by concentrating on quality, but dividing it into six different factors – existing debt load, fiscal position, economic growth, external creditors, net asset position and governance. The portfolio is tilted towards the sovereigns with good and improving scores. Presenting the case for this strategy, he says: “At times the market can be a little gung-ho and dismiss negative news but, ultimately, quality comes back to affect these markets.”
He gives an example: “For a long time investors in Turkish bonds can ignore concerns about the economy, but the time will come when the market says ‘we need to be rewarded for this risk’.” O’Leary says that this style of investing works better than in developed markets because emerging markets have more crises, when debt that scores weakly on some or all of the SSGA factors suffers. Investors seem to agree. O’Leary refers to the “very successful start” of its smart beta emerging market fixed-income strategy, which has grown to $220m (€207m) under management since the April 2016 launch.
China Post Global, the international asset management arm of China Post Fund, will this spring launch two factor-based ETFs investing in China A-shares that will, like SSGA’s bond offering, each focus on a specific factor. One will be founded on quality, and the other on volatility, through a minimum-variance strategy. “There is some concern among international investors about volatility in Chinese equities,” says Danny Dolan, London-based managing director. “A minimum-variance strategy is a good solution to this; our research shows that it has reduced risk, while consistently outperforming market cap-weighted indices, over the past five years.” He adds that the China quality strategy has also outperformed market-cap weighted indices over the same period.
Information is scant on the actual performance of emerging-market factor investing funds, rather than back-testing, because the field is so new. However, Acadian’s emerging-markets strategy provides a good example of the possibilities of multi-factor investing. Acadian uses 20 factors, made up of more than 70 underlying individual components. Between its launch at the beginning of 1994 and the end of 2016, the strategy has produced a net annualised return in dollars of 6.2%, compared with 4.4% for the MSCI Emerging Markets index.
But even if factor-investing returns in emerging markets can be good for all the reasons given above, sceptics can argue against the case for investing in them by suggesting that the same virtues might also be ascribed to conventional active management. A good active manager should, at least in theory, be able to profit from the particularly prevalent mispricing of emerging market stocks, just as a factor investor might.
Specialists in factor investing also acknowledge that the boundary between conventional active investing and factor investing is blurred. “In many cases, active managers are doing more than stock-picking,” says Dolan of China Post Global. “They are also following a kind of loose version of factor investing themselves, or investing with a factor tilt.”
But although factor investing has much in common with conventional active management, there is a crucial difference – the price. “Active management may not be ideal from the fee point of view,” says Dolan’s colleague in London, Evie Lamprou, head of distribution for Europe. Dolan says China Post Global’s ETF management fees will be between 70 and 75 basis points – much more than the average passive ETF, but much less than some conventional active managers may charge.
Despite the enticement of lower fees and the prospect of potentially higher returns than market cap-weighted indices, emerging-market factor investing is still pretty small. The total value of emerging-market ETFs using smart beta – a term broadly, though not entirely, synonymous with factor investing – is €5.5bn, according to TrackInsight, an ETF selection platform, out of a total of €184.1bn in all emerging market strategies.
Advocates of factor investing in emerging markets are not, however, crestfallen. Some say strategies that begin in developed markets tend to take a while to seep through into emerging markets – and factor investing is large in developed markets.
Lyxor’s minimum variance strategy for emerging markets has reached only $45m in assets since June 2015, compared with $450m worldwide.
However, François Millet, product line manager for ETFs and indexing in Paris, is optimistic that assets under management in emerging market smart beta will grow, because of his calculations that minimum variance products reduce annual volatility in the notoriously volatile emerging market stock sector by 25-30%.
“I don’t know when smart beta will come to emerging markets,” he says. “But it will come.”